The IRS issues favorable advice for restaurants under section 263A

INSIGHT ARTICLE
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October 31, 2014

In a recent memorandum, CCA 201439001 (the CCA), the IRS Office of Chief Counsel addressed the application of the simplified production method under section 263A versus other reasonable methods with respect to capitalizing costs to the ending inventory of restaurants. Under section 263A(a) and Reg. section 1.263A-1(a)(3)(ii), taxpayers are generally required to capitalize the direct and indirect allocable costs of producing real or tangible personal property. With respect to produced property, Reg. section 1.263A-1(e)(3)(i)(A) explains that indirect costs include all costs other than direct material costs and direct labor costs that directly benefit or are incurred by reason of the performance of production activities. Applied to the restaurant industry, the activity of processing and combining ingredients for sale to customers is generally considered a production activity, and, thus, direct and indirect costs incurred with respect to this activity are subject to certain capitalization requirements under sections 263A and 471.

To allocate direct and indirect costs, producers may use a specific identification method, standard cost method, burden rate method, or any other reasonable allocation method as defined under the principles of Reg. section 1.263A-1(f)(4)). In addition, Reg. section 1.263A-1(f)(1) allows producers to use the simplified production method under Reg. section 1.263A-2(b). The simplified production method assumes that costs are incurred evenly through the entire production process. Thus, for taxpayers that incur the bulk of production costs during the final stages of production or have a disproportionate amount of unprocessed raw materials, the simplified production method can result in the capitalization of more costs than other reasonable methods.

After encountering numerous restaurant industry taxpayers that had not capitalized under section 263A certain back-of-the-house costs incurred to produce food, including cook and preparation-cook wages (collectively, kitchen labor), IRS examination agents requested advice from the Office of Chief Counsel on whether the simplified production method should be imposed on such taxpayers.

Taxpayers in the restaurant industry often have ending inventories consisting entirely, or almost entirely, of ingredients that have not yet entered the restaurant's production process. Accordingly, if these taxpayers were required under the simplified production method to capitalize kitchen labor and similar costs, the use of this method would lead to a significant amount of those costs being capitalized to the raw materials in ending inventory even though these costs typically relate almost entirely to the production of food that is no longer on hand. This would present a potential economic inventory distortion for taxpayers in the restaurant industry since kitchen labor almost entirely represents a direct production cost allocable to goods sold throughout the year, not to the ending inventory of raw materials on hand. The distortion would be even greater if a restaurant had a significant amount of alcohol on hand at the end of the year. However, if kitchen labor were treated as a section 471 cost under the simplified production method or a more precise facts-and-circumstances method, these costs would be allocated to cost of goods sold.

The CCA indicates that the simplified production method should not be imposed during an examination or litigation if the taxpayers are willing to develop and implement a reasonable facts-and-circumstances method instead. In addition, those in the restaurant industry that want to use the simplified production method should be allowed to treat all of their direct production costs (including kitchen labor) as section 471 costs. The chief counsel’s response provides welcome and taxpayer-friendly advice, allowing taxpayers to use a facts-and-circumstances approach to determine a reasonable allocation method. This will generally result in the majority of indirect kitchen labor and other costs being allocated to cost of goods produced rather than to ending inventory.

There are three items to note in this CCA. First, the IRS has a number of restaurants under examination. Second, the IRS generally considers restaurants to engage in production activities under section 263A. Third, the IRS will permit restaurants to use a reasonable facts and circumstances approach to capitalizing kitchen labor and other similar costs and will allow those taxpayers using the simplified production method to treat kitchen labor in a manner that should reduce distortion. Taxpayers in the restaurant industry should contact their tax advisors to discuss the implications of this CCA.

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